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Life Insurance Investments

What are they?

These are investments offered by insurance companies that include some life cover within the product. In many cases the life cover is nominal and is simply there to
comply with rules and regulations, so the focus is really on investment.

While similar in some ways to other fund investments such as unit trusts, life insurance investments are taxed very differently. This often makes them less
attractive than alternatives, although in specific situations the tax treatment can be advantageous.

Non-taxpayers should avoid life insurance investments like the plague. Insurers must deduct basic rate tax from income and gains within the fund and this can never be
reclaimed.

What types are there?

There are two main types of life insurance investment, they can be thought of as tax 'wrappers' that surround fund investments:

Investment BondsQualifying Policies (endowments)

Investment bonds are single premium life policies where the money is invested in a fund. However, as the life cover is normally just 1% above the value of your fund it's
irrelevant, these are primarily investments.

While you can potentially hold a wide range of investment funds (similar to unit trusts) within an investment bond, they've sadly been mostly used to sell mediocre
insurance company funds in the past - giving them a bad reputation. This has been fuelled by many insurers paying ridiculously high sales commissions.

Qualifying policies are so-called because on meeting certain criteria they qualify for no tax on income or gains at maturity. However, because income and gains will have
already been taxed at basic rate they're not as attractive as they might at first sound, plus contributions are capped at £3,600 a year.

The main criteria for a life insurance policy to 'qualify' are:

Have a premium payment term of at least 10 years.

The sum payable on death must be at least 75% of the total premiums payable over the term.

The policy must not be surrendered within the first 10 years or three quarters of its term, whichever is lower.

Some qualifying policies are more orientated towards life cover than others, but most are usually sold as investments with a bit of life cover included. Whichever you choose,
you'll have to commit to regular payments (usually monthly) over the full term of the policy. Stop the payments and you could face a penalty and/or a tax bill for doing so.

The best known variant of qualifying policy is endowments, which have an appalling reputation thanks to high charges and poor performance being commonplace. Silly
levels of sales commission have encouraged far too many salesmen and advisers to peddle these. Maximum investment plans (MIPs) offer the minimum level of life cover
and place maximum focus on investment, but they're still often little better than endowments.

What types of underlying investments are available?

Both investment bonds and qualifying policies usually allow you choose from a range of investment funds. Thankfully it's becoming more common for insurers to offer funds
from across the marketplace rather than just their own. The most common options are as follows:

With-ProfitsManagedSpecialist

With-profits has traditionally been the most commonly sold type of insurance company fund, although it's popularity has waned in recent years.

The concept is simple. Your money is invested in a mix of shares, fixed interest and commercial property to spread risk. The insurer then tries to smooth your investment
returns using annual ('reversionary') bonuses and reserves. In good years the bonuses are lower than the underlying fund return, allowing reserves to be increased. The
reverse happens in poor years. At maturity or encashment, any surplus reserves are typically paid as a final (or 'terminal') bonus.

Although a with-profits fund shouldn't fall in value, you may be penalised when you sell if receiving your fund value would mean getting more than your fair share of
reserves at the expense of remaining policyholders. This penalty is called a 'market value adjuster' (MVA).

Sounds good in theory, but in practice there's been several problems.

Many insurers have proved to be poor at managing the underlying investments.

Weaker funds invest mostly in cash and fixed interest as their reserves are too small to risk investing in shares and property, where longer term returns are likely to be
higher.

Many with-profits funds are suffering from a lack of reserves, meaning market value adjusters and paltry final bonuses have been commonplace over the last few years.

With-profits is very opaque, it's very difficult for investors to see exactly what's going on day to day.

These problems, coupled with poor general performance, have led to many investors deserting with-profits for potentially more attractive alternatives.

Most insurance companies offer managed funds, where they'll invest in shares, fixed interest and sometimes property. These are sometimes called 'distribution' funds, where
the aim is to produce some income as well as capital growth.

Managed funds are not a bad idea, but most insurance companies have proved over the years that they're not very good at it. Usually better to use a
managed fund run by a specialist fund manager rather than an insurer. Also check the split between the various underling investment types, as they can vary widely between
funds. For example, while one might invest mostly in shares, another might favour fixed interest - the results could be quite different.

Most insurers offer funds specialising in certain areas, e.g. worldwide stock markets, corporate bonds and commercial property. They'll probably offer a few run by
their own managers, but the better insurers (and fund supermarkets) also offer funds managed by other specialist fund providers. Choose the latter and you should be able to
build a decent investment portfolio, in much the same way you would with unit trusts.

Given the outlook for with-profits is not particularly bright, should you surrender your policy and invest the proceeds elsewhere?

It's by no means a straightforward decision, but considering the following issues could help you decide:

What are the prospects for your policy?
The financially stronger your with-profits provider, the better. This allows them to have a higher equity backing ratio (as they have sufficient reserves to weather short
term volatility) which should mean better longer term performance prospects for the fund.

Is the surrender value fair?
If your with-profits provider applies a MVA to your policy, is it at a fair level? If yes, then moving elsewhere might still make sense even if you make a loss on the existing
fund. However, a penal MVA could leave you having to attain unrealistic investment returns elsewhere to compensate, so staying put in the hope the MVA falls in future is
probably more wise.

One way to check whether a MVA is fair is to compare performance of your with-profits fund with a comparable managed fund run by the same insurer, typically a 'balanced'
managed fund. If the surrender value of your with-profits fund is greater than the notional value of the comparable fund over the same period it suggests the 'smoothing'
process may have worked in your favour.

If you have a with-profits bond then always check whether you're allowed to surrender without a MVA on a specified date, e.g. the fifth or tenth anniversary. If so and
you're close to that date, it usually makes sense to wait.

Taxation (with-profits bonds)
If the surrender value plus any withdrawals is greater than the original sum invested, check whether surrendering will leave you with a tax bill. For more details view the
tax section later on this page.

If you decide to surrender then think very carefully about how you reinvest the money. You don't want to jump out of the frying pan and straight into the fire!

Charges

Life insurance investment charges tend to be more complex than investments such as unit trusts. There's a simple reason for this, insurers often pay very high sales
commissions which need to be funded by charges. By using smoke and mirrors (i.e. complex charging arrangements) they try to hide these from investors and make their products
look competitive. In fairness, not all insurance company investments are more expensive than unit trusts and some are actually cheaper, but in the main they're needlessly
complex.

When looking at costs, it helps to separate the charges for the bond or qualifying policy 'wrapper' from the costs of the underlying fund(s).

Product 'Wrapper' CostsFund Charges

Investment Bonds

Many insurers levy an initial wrapper charge when you buy an investment bond through what's called 'allocation rates'. These are simply a charge in disguise, e.g. an
allocation rate of 95% is the same as a 5% initial charge. You often find that the more you invest the higher the allocation rate, i.e. the lower the initial change

Furthermore, if you decide to sell your bond within the first five years you might also be stung with an exit penalty. While these charges tend to fall year by year, they
can be as high as 10% during the first year. Insurers charge these to recoup the money they've paid out as sales commissions and administration costs etc. but they're simply
rubbing salt into your wounds if you've bought a lemon and wish to get rid.

Some insurers also charge an annual fee for their bond wrapper, although annual fees are more typically levied via the underlying investment fund.

Qualifying Policies

These policies (including endowments) usually take the majority of their charges during the first year or two, as they foolishly pay salesmen and advisers almost all
the commission upfront. This makes them a total waste of time unless you're likely to hold the investment until maturity (and even then they're still arguably a waste of
time!). Don't be surprised if the value of your policy is near zero at the end of the first year.

Depending on the policy you may have an initial charge (typically up to 5%) on the underlying fund(s) held in your bond or qualifying policy wrapper.

Even if there's no initial charge, you'll almost certainly pay fund annual charges. These tend to be around 1% for an insurer's own funds and 1.5% for funds run by
other managers.

Note, with-profits funds don't normally quote an explicit annual charge, as charges are deducted behind the scenes and taken into account when annual bonuses are
declared.

Reduction in Yield (RIY)

Thankfully insurers have to combine the impact of all these charges into a single 'reduction in yield' (RIY) figure. The RIY shows by how much they expect their charges
to reduce your annual investment return, usually based on an assumed annual growth rate (before charges) of 6%. For example, charges could reduce a 6% annual return to 4.2%,
a RIY of 1.8%. Always compare the RIY between products and providers to get a clearer idea of overall costs.

Tax

Insurance companies must pay basic rate tax on both income and gains within their life insurance investment funds, hence all returns are paid net of basic rate tax
(regardless of whether the fund is held in a bond or qualifying policy).

Non-taxpayers cannot reclaim the tax that has been deducted, making these investments pointless from their point of view.

Basic rate taxpayers have no further tax to pay (because basic rate tax has already been deducted), so investment bonds and qualifying policies are neutral to them.

Higher rate taxpayers must pay the difference between basic and higher rate tax, currently 20%, on both income and gains from
investment bonds.

Top rate taxpayers must pay the difference between basic and the top rate of tax, currently 25%, on both income and gains from
investment bonds.

Provided a qualifying policy has 'qualified' then there's no further tax to pay, a potentially useful saving for higher and top rate taxpayers.

There's also a fundamental difference in the way investment bonds are taxed. You can withdraw up to 5% of your original investment each year without further tax to pay at
that time. Any further tax on these withdrawals is instead owed when you decide to sell. For example, if you withdraw 6% then any further tax owed on the first 5% is
deferred until maturity and the remaining 1% is added to your other income for that tax year and further tax paid if it falls into the higher rate tax band.

The tax owed at maturity or sale is calculated using a method called 'top-slicing'. This means higher rate taxpayers can defer and, in some circumstances, actually avoid
having to pay extra higher rate tax on the 5% withdrawals.

Top-slicing is the calculation used to determine whether you owe any tax on maturity or sale of an investment bond, as follows:

Take the amount received on the sale of the bond and add all previous withdrawals (including the 5% withdrawals).

Subtract the total amount you've paid in plus the excess of any withdrawals over 5%, which gives your total 'profit'.

Divide this profit by the number of complete years you've held the investment bond, to give a 'profit slice'.

Add the profit slice to your taxable income for that year, any part of the slice that falls into the higher rate tax band is liable to extra tax
(at the difference between basic and higher rate).

Multiply the tax due on the profit slice by the number of complete years you've held the investment bond to get your total tax bill.

This benefits those who are higher rate taxpayers while they own an investment bond except for the year of maturity, when their taxable income is sufficiently low that
the profit slice doesn't push them into the higher rate band - perhaps because they've just retired.

Example

Mr Planner, a higher rate taxpayer, invests £50,000 into an investment bond for 10 years, making four withdrawals of £2,500 each (i.e. 5%) during that time.

At maturity Mr Planner receives £90,000. To calculate his tax liability he must first add all previous withdrawals (i.e. 4 x £2,500), giving a total £100,000.

Next he must subtract the initial £50,000 investment which leaves £50,000.

To get his profit slice Mr Planner divides £50,000 by 10, the number of complete years he's held the GIB, to get £5,000.

As a higher rate taxpayer in the year of maturity his whole profit slice is taxable at 20%, equal to £1,000.
This is multiplied by the number of complete years, 10, to get Mr Planner's tax bill of £10,000.

If Mr Planner were a basic rate taxpayer in the year of maturity and the profit slice pushed his taxable income into the higher rate band, then extra tax is payable on that
part of the slice. If, say, half the slice fell into the higher rate band, then £2,500 of the £5,000 profit slice would be taxed and his overall tax equal
to £5,000.

If Mr Planner's taxable income in the year of maturity was such that the profit slice did not push his income into the higher tax band, then he'd have no tax to pay.

Age Allowance

If you're aged 65 or over investment bonds can be both good and bad news regarding your increased age-related income tax personal allowance.

Good News

Bad News

Any withdrawals within your 5% annual allowance don't affect your age allowance in the year they're taken.

When the bond matures or is sold then the total gain (which includes all annual withdrawals up to 5%) is notionally added to your income that year,
potentially reducing or wiping out your extra age allowance. While you might not have any additional tax to pay on profit, you could lose out due to a reduced/lost
age allowance.

Offshore

If a life insurance investment is held offshore (i.e. outside the UK), then the insurer does not normally have to deduct basic rate tax from income and gains. If you're
UK tax resident then you'll still have to pay tax on income and gains when taken (at whatever tax band they fall into), but at least you benefit from the fund not being
taxed meanwhile (known as 'gross roll-up').

£100,000 invested for 20 years with a 6.00% annual return, a 20% tax rate and no withdrawals.
If tax is deducted throughout (i.e. onshore) the bond would be worth £255,403
If tax is deducted at the end (i.e. offshore) the bond would be worth £276,571
Gross roll-up has boosted the bond's value by £21,168.

Offshore bonds are often more expensive than onshore, but can be advantageous for those investing large sums that'll benefit most from gross roll-up.

When might investment bonds be a good idea?

Unless you're a higher rate taxpayer there's really no point using an investment bond. Even as a higher rate taxpayer, you should look to use your annual individual
savings account (ISA) and capital gains tax (CGT) allowances before you consider an investment bond. If you do invest you're likely to get the most benefit if you're in a lower
tax band (ideally a non-taxpayer) when you come to surrender the bond than the one you were in while owning it. You could transfer ownership of the bond to another adult
(e.g. your spouse) using a 'deed of assignment by way of a gift' without invoking a tax liability on the transfer, useful if they're in a lower tax band than you.

When might qualifying policies be a good idea?

Almost never! The only possible argument is that they could benefit someone who is a higher rate taxpayer throughout the period they own the policy and at maturity. They
would save paying additional higher rate tax on any investment return, although using annual ISA and CGT allowances would be far preferable.

How quickly can I get my money back?

Subject to penalties, you can surrender a life insurance investment and usually receive your money within a week or two.

However, bear in mind you may have a tax liability and that the surrender values on qualifying policies in the early years are usually very low. You might get a better
price by selling through a traded endowment broker.

What are traded endowment policies (TEPs)?

TEPs are basically second hand endowment policies. Suppose you have a 20 year with-profits endowment and decide after 12 years you can longer afford the premiums or you
simply don't want it anymore. Your could stop paying premiums until maturity, known as making the policy 'paid up', although charges could eat into your policy. If you want
your money back now then surrendering your policy is an option, but the insurer is likely to offer you a derisory sum. You could get more money by selling the endowment to
someone else, usually via a traded endowment broker.

Why would someone want to purchase your endowment? Well, in return for continuing to pay the premiums until maturity they might make a worthwhile profit on what they paid
you for it. They'll benefit from you already having paid the majority of policy charges, but much of their potential profit will depend on how much the insurer pays as a
final bonus, so buying a TEP is not without risk. If you die before maturity, the new owner will receive the life insurance payout.

If you buy a TEP then any profit at maturity will be subject to capital gains tax, provided the policy has 'qualified'. If the policy is 'non-qualifying' then any profit
at maturity is subject to income tax, calculated using the 'top-slicing' method.

How can I buy?

There are several ways to buy life insurance investments, the route you choose could have a big impact on how much you pay. Whichever route you choose the minimum
investment is likely to be £5,000 for investment bonds and £50 per month for qualifying policies.

InsurerFinancial AdviserDiscount Broker

Buying life insurance investments directly from an insurance company is normally the worst of all routes. You'll pay the full charges but get no advice or guidance.

There's no benefit in taking this route, so avoid.

Traditionally life company investments paid high sales commissions to financial advisers. However, as commissions may no longer be paid where advice is given financial advisers will charge you a fee
for their services and should use lower cost products without commisison built into their charges.

If you're fairly comfortable deciding yourself which policy to buy, then this should prove the cheapest route. Discount brokers don't give advice, but will either share with
you the commission they receive from insurers or charge a low admin feeand use products without commisiosn built in.

Jargon

Here's some of the more common life insurance investment jargon you might come across:

Jargon

Meaning

5% Withdrawal

The amount of your initial invesment bond investment that can be withdrawn each year with no tax liability at that time (it's calculated at maturity).

Distribution Bond

A type of investment bond that provides a regular income.

Equity Backing Ratio

The proportion of a with-profits fund that is invested in shares and property.

Investment Bond

A single premium life policy where the money is invested in a fund. Basically a type of insurance company investment with it's own set of tax rules.

MVA / MVR

Market value adjuster / reduction. A charge applied to some investors wanting to sell their with-profits investments during or after periods of poor performance.

Qualifying Policy

An insurance company regular savings plan with included life cover, e.g. endowment. If certain criteria are met there's no further tax at maturity, although they're taxed at basic rate by default.

Reduction in Yield

A figure that insurance companies must show for each product to illustrate the impact that all of their chages will have on potential investment returns.

Top-Slicing

The method by which the amount of tax owed, if any, is calculated when an investment bond is surrendered or matures.

Traded Endowment Policy

A second hand endowment policy, can offer reasonable value for investors and a better deal for sellers than if they surrendered the policy.

With-Profits

A type of investment fund run by insurance companies. In theory they smooth out investment ups and downs by holding back some profit in good years to distribute in bad years.